How Costco gets firms to compete with themselves

 In my ECONS101 class last week, we covered pricing and non-price strategy for firms. This is a topic that you wouldn't see in a 'typical' first-year economics principles class, because it covers some very applied business economics and managerial economics - pretty important stuff for business students to understand, but not seen by most principles lecturers as important enough to squeeze out all the excitement of teaching the principles of cost curves (!).

Anyway, one of the strategies that I cover in this topic is situations where a firm finds it profitable to compete with itself. The examples I use are firms like Unilever, which makes several different brands of laundry powder, effectively making its own products compete with each other. However, by crowding the market with its own brands, Unilever makes it more difficult for other firms to compete. There is limited space on supermarket shelves, so if you can fill up those shelves with your own products, then it increases your profits. The supermarkets play along, because it is lower cost for them to deal with one supplier that can supply a range of products (and therefore make it look to the customer like a wide variety), rather than dealing with many suppliers.

So, I was really interested to read this article by Adam Keesling last month, which illustrates something fairly similar:

If you’re anything like the nearly 100 million people worldwide who have a Costco membership, you probably love Costco’s Kirkland Signature. You can get two dozen cage-free eggs for $6.50, or a 1.75-liter bottle of French vodka for $19.99. 

But despite these products’ exceptional prices, their quality doesn’t suffer at all. In fact, the exact opposite is true. Many of their products pass purity tests with flying colors. 

Kirkland also has a passionate and loyal fan base — not something you typically find with a private label brand. One guy even got a Kirkland Signature tattoo on his left arm and held his 27th birthday party at the Costco food court. 

Kirkland’s success defies our intuition and experience. Shouldn’t lower prices lead to lower quality products? How can they offer rock-bottom prices but still have some of the best products around? 

The answer is this: they get the best manufacturers in the world — who already have products on Costco shelves — to make Kirkland products. Yeah, you read that right. While customers might not know it, Kirkland products are often made by the same manufacturers who make the branded products that sit next to them on the shelves. 

Now, we don't have Costco in New Zealand. However, the explanation of the economics underlying how Costco gets its suppliers to compete with themselves is eye-opening:

Shortly after learning that brands would actually manufacture and package Kirkland products for Costco, I wondered how it worked. Why would a brand — say KIND Bars or Jiffy Peanut Butter — create a product for Costco and use the Kirkland brand? And make it 1% better than their own product? 

In a normal Costco purchasing example, a company might sell their product for $0.95 and Costco might retail it for $1.00. This would result in a 5% margin (in reality the margin is a bit lower, but let’s use these numbers for estimates). 

This $0.95 would be the brand's revenue. If we use some industry averages for margins — marketing budgets average 24% for CPG brands, and gross margins hover around 40-50% — then we can estimate their cost profile.

Keesling estimates that the manufacturer earns about 16% profit on selling their standard product at Costco. Then:

What about Kirkland products? As mentioned above, Costco aims to save customers 15-20% on the Kirkland products compared to their branded counterparts. So in our example, retail price would be $0.80 per unit for the Kirkland products. If that’s the only adjustment, the brand would be in a tricky position. Marketing expense is $0.20, non-marketing expense is $0.60 and the retail price is $0.80. That wouldn’t leave much margin for either the brand or Costco. In fact, it would leave none at all. 

But here’s the kicker: with the Kirkland products, brands don’t have to spend nearly as much money on marketing. They don’t need to pay for Facebook ads or run television campaigns. The only remaining marketing expense might be the account reps associated with the Kirkland account. Let’s say this lowered the marketing expense from $0.20 per unit to $0.05 per unit.  

In this case, Keesling estimates that the manufacturer earns about 14% profit on Kirkland products. So, while it's not the same level of profit as for their standard product, if selling the Kirkland product is what it takes to get your standard product on Costco shelves, then many manufacturers would be willing to do so. After all, Costco is bringing in revenue of nearly US$150 billion per year, so the manufacturers know they are going to sell a lot of products if they are on Costco shelves.

And that is how Costco gets firms to compete with themselves.

[HT: Marginal Revolution]